Why the Bond Market is Ignoring Inflation
Some months ago, as the snow melted off the lawn, a rabbit appeared at the end of our back yard. Our twin shih tzus, Buddy and Bruiser, spotted the intruder and, barking furiously, headed off in pursuit. The bunny, having given our fearless duo a head start, then bounced off into the undergrowth, cotton-tail waving in the air, leaving them barking at each other as if to say “Where’d he go? Where’d he go?”
In the weeks that followed, there were plenty of repeat performances, always ending in the same manner. But by now, frankly, Buddy and Bruiser have surrendered. The rabbit, (or I should say rabbits as they now, somewhat ominously, appear in pairs), edge ever closer to our house and stare at the dogs in a distinctly taunting manner. But Buddy and Bruiser simply eye them lethargically, having given up the chase.
Bond investors seem to be regarding rising inflation in a similar manner. Recent reports have shown consistent upside surprises on measures of wages, home prices and consumer prices, culminating in last Thursday’s red-hot May CPI report, which showed a 5.0% year-over-year gain in overall CPI and a 3.8% increase, excluding food and energy. However, despite this, long-term interest rates have edged down, with the 10-year Treasury yield falling to 1.45% on Thursday, its lowest level since the start of March.
There are two broad possibilities for why this is happening.
First, it could be that investors see some weakening in the pace of recovery and agree with soothing commentary from Fed officials who assert that any price pressures showing up today are merely part of a transitory interlude before a return to stable or falling inflation.
Or, second, it could be that technical forces in the bond market are suppressing long-term interest rates, at least for now.
For investors, it is important to pay attention to this debate because. If the Fed is wrong and higher inflation does indeed become imbedded into the economic landscape, technical forces should eventually subside, allowing long rates to move higher and restarting the rotation from growth to value which has characterized much of this year so far.
Is the Risk of Higher Inflation Really Declining?
Those arguing that inflation pressures are actually easing could point to two consecutive jobs reports that have disappointed both with respect to payroll gains and declines in unemployment. To be sure, there is nothing wrong with average job gains of 419,000 over the past two months or a 0.2% decline in the unemployment rate to 5.8%.
However, in an economy where payroll employment is still 7.6 million jobs lower than before the pandemic and the unemployment rate is 2.3 percentage points higher, this progress seems painfully slow.
That being said, healing in the job market is, most likely, just being delayed by a few months due to the remaining impact of the pandemic and relatively generous unemployment benefits. The economy continues to reopen rapidly and enhanced unemployment benefits will expire in half the states by early July and the other half by early September.
This, combined with clear evidence of extraordinary labor demand, (as confirmed by last week’s JOLTs report), should lead to a very rapid increase in employment and decline in unemployment over the next six months. In the meantime, wage growth has clearly accelerated and this should continue to add to inflation pressures into 2022.
In addition, further fiscal stimulus looks likely before the end of the year, composite PMI data show global economic activity accelerating at its fastest pace in 15 years, and West Texas Intermediate Crude oil prices closed out last week at over $70 per barrel for the first time since October of 2018.
Mapping all of this into our economic models suggests inflation in the fourth quarter of between 3.5% and 4.0% year-over-year as measured by the personal consumption deflator which is the Fed’s favorite inflation gauge.
To be fair, the bond market has priced in at least some of this higher inflation with the yield gap between 10-year nominal Treasuries and 10-year TIPs ending last week at 2.32%. Still, the evidence would seem to support further upside risks to inflation. More significantly, the real 10-year TIP yield remains at an astonishingly low -0.85%. To be clear, this means that an investor buying a 10-year TIP today and holding it to maturity is locking in a guarantee of losing 8.2% of their purchasing power over the next 10-years for the privilege of being allowed to lend money to Uncle Sam.
Technical Forces suppressing inflation
This reality suggests that something else, other than expectations about the economy or inflation, is suppressing yields in a big way.
One part of the story continues to be low foreign yields. A more sluggish recovery from Covid, relatively low inflation and very easy ECB policies are maintaining 10-year German government bond yields at roughly -0.25% while the Japanese Central Bank is holding 10-year JGB yields at close to 0%. To the extent that global investors see these bonds as substitutes for U.S. Treasuries, their consistently low yields are likely acting as an anchor on U.S. yields.
A second issue is portfolio rebalancing. Since the start of the year, the S&P500 has generated a sparkling return of 13.6%. This has prompted many institutional and individual investors to rebalance, buying bonds and selling stocks. As one measure of this, according to the Investment Company Institute, more than $350 billion has flowed into long-term bond funds and ETFs so far this year compared to just $152 billion on the equity side.
However, the biggest factor may be a temporary lull in the supply of Treasuries. This is not for a lack of stimulative fiscal policy. In fact, in just over four months, between February 3rd and June 9th, federal outlays exceeded federal revenues by a whopping $1.327 trillion.
Over that same period, the Federal Reserve added $328 billion in Treasuries to its balance sheet as part of its bond-buying program, funding some of this deficit spending.
However, the actions of the Treasury Department have been even more significant and they trace back to events of a year ago.
In the second quarter of 2020, as the economy collapsed into the pandemic recession, the Treasury Department issued almost $3 trillion in additional debt. This was, in fact, well above their cash needs and so they parked the surplus in their general account at the Federal Reserve which swelled to a peak of almost $1.8 trillion by the end of July, 2020. This gigantic stash of cash stayed in this account, more-or-less untouched into early 2021 when the Treasury Department announced that they would be drawing it down to roughly $500 billion by the end of June.
They have stayed on this schedule with the account shrinking from $1.630 trillion on February 3rd of this year to $674 billion by June 9th. The net impact of this is that, despite very significant fiscal stimulus over this period, total Federal government debt in the hands of the public, excluding the Federal Reserve, rose by just $13 billion over the same period.
It would seem that these factors are more than enough to explain the lack of bounce in Treasury yields in recent months. However, they will likely not last forever. Both Europe and Japan should continue to make progress against the pandemic in the months ahead, potentially putting some upward pressure on their yields. At some stage, equity markets could see a significant correction, requiring investors to rebalance towards stocks rather than bonds. The Treasury drawdown of its account at the Fed is nearing its end and we expect that this week’s Fed communications will hint at a tapering of Fed bond purchases by the end of this year or early next year.
If this transpires, then long-term interest rates will likely resume their ascent, and this should benefit fixed-income investors who are short duration and equity investors who are tilted towards value over growth.